Markets price securities badly when the people selling them are not answering the price question. That happens rarely in ordinary trading and constantly around corporate events, because an event distributes securities to holders chosen by an accident of history rather than by appetite.
Five mechanisms do almost all of the work, and they are worth ranking by how reliably they produce a gap rather than listing as equals.
The strongest is mandate-driven selling. An index fund that tracks a large-capitalisation benchmark and receives a small-capitalisation spin-off has to sell it, at whatever price the book offers, inside a window set by its own tracking rules. A credit fund that receives a warrant in a restructuring is in the same position. This selling is genuinely price-insensitive, it is announced in advance in the index provider's methodology, and it can be sized before it happens. Everything else on this list is softer.
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Next is absolute size. A spin-off with a market capitalisation of $960 million is uninvestable for a fund that cannot take a position below $50 million without owning more than 5% of the company. The selling that follows is not forced by a rule but by an economic reality, and it is just as real.
Third is complexity that costs more to resolve than the position is worth. A rights entitlement with a renunciation window, a warrant with an adjustment clause, a scheme of arrangement running to 200 pages: each requires an hour of somebody's attention for a position that might make a rounding error's worth of difference to a large fund. The work does not get done, and the security trades at whatever price the people who did no work will accept.
Fourth is coverage. A newly separated company has no analyst model, no consensus estimate and no investor-relations history on its first day. Information that is public but unprocessed is the cheapest information there is.
Fifth, and weakest as a source of durable edge, is the tax and calendar overlay. Year-end selling, the desire to be seen holding respectable names in a reporting period, and the reluctance to explain an odd position to a committee all move prices at the margin. They also reverse quickly.
The problem with this list is that it explains too much. Every ugly, cheap, small security has one of those five stories attached to it, and most of them are cheap because they are bad. So the working discipline is not to recognise the mechanism but to test it, and four tests do the job.
What are the four tests for an event-driven situation?
Test 1 asks about the mechanism. Can you name the seller and size the position they must dispose of, in days of the security's own trading volume? A named seller holding 45 days of volume is a fact. "There is probably technical selling" is a feeling. The arithmetic is one line: the forced holders' share of the float, times the market capitalisation, divided by the expected daily traded value.
Test 2 asks about the gap. Is the discount to a conservatively computed value larger than the total cost of holding the position until the gap closes? That cost is not zero. It includes the time your capital is committed, the tax on the gain when it arrives, the bid-ask spread on the way in and out of an illiquid security, and, on a stub or a warrant, the possibility that the position is worth nothing.
Test 3 asks for the closer. What specific, dated event ends the selling and forces the price to acknowledge value? Index reconstitution, the first standalone quarterly result, the first analyst initiation, the expiry of a lock-in, the record date on an entitlement. If the answer is "eventually the market will notice", you own a cheap security and not a special situation, and you should size it as the former.
Test 4 asks what the seller knew, and it is the most valuable of the four as well as the one most often skipped. Ask why the parent shed this business, what liability travelled with the asset, how much debt was pushed into the entity on its way out, and whether the discount is explained by a governance arrangement rather than an accounting one. A spin-off loaded with the parent's pension deficit and half its debt is not mispriced. It is priced.
How do you score the four tests?
Score each test 0, 1 or 2, require six of eight, and require that no test scores zero. The last condition matters more than the total. A situation scoring 2, 2, 2 and 0 is one where you have found a large gap, a real forced seller and a dated catalyst in a business whose problems you have not understood. That combination is the shape of most permanent losses in event-driven investing.